Keeping Interest Simple (Warning – Dry Subject Ahead….)

Whether it’s for a mortgage, a home equity line of credit, student loans or credit cards, most of us are paying interest on at least one and often more than one debt.

The interest rate is going to be different for each obligation, but it generally is calculated in the same way for all of them.

As common as it is for people to pay interest, and for as much interest as is paid out by consumers each year, many people really don’t understand how interest is calculated.  As a result, they don’t realize how much of what they pay out each month goes to interest payments to benefit the bank or credit card issuer, and how little remains to pay down principal, which benefits the loan payer.  While a good understanding of this will likely dissuade only a very few from incurring new debts, it may persuade a larger number to make a more determined effort at paying off those debts as quickly as possible.

Think of interest as the rent you pay for the use of someone else’s money.  Your rent is based on the rental (interest) rate, how much money you’ve been using (the principal balance), and how long you’ve been using the money (the time between payments).

Interest can be computed by assuming a fixed period of time between payments, called “monthly” or “360 day” interest.  It can also be computed based on the actual time between payments, called “daily” or “365 day” interest.  This is far and away the most common method employed.  Using the actual time between payments is more fair to you, since you are only paying “rent” for the number of days that you used the money before the principal was reduced following a payment.  To continue with our analogy, you are renting by the day, but writing a check approximately once each month to pay the interest accrued since the last payment.  This is to your benefit as it means more of your payment is applied to principal.  The more your loan balance is reduced today, the less interest you pay in the future.

To compute interest due, multiply your current balance by the interest rate (as a decimal) and divide the answer by 365.  The result is the interest for one day (daily interest).  Next, count the days between this payment and the last one.  Multiply the daily interest by the number of days to get the total interest.

For example:

$200,000 loan principal

8%  =  interest rate

200,000 x .08  =  16,000

16,000/365  =  43.84  =  $43.84 daily interest

1^st payment

Interest began accruing on the 1^st of the month, and you made a payment of $1,467.53 on the 30^th day of the same month. [The $1,467.53 payment is based on a 30 year amortization schedule, which is commonly used even if the loan is for a shorter period with a balloon payment at the end.]

$43.84  x  30  =  $1,315.20

So, you paid $1,315.20 in interest, which left $152.33 to be applied to principal.

$200,000 – $152.33  =  $199,847.67 (this is your new principal balance)

2^nd payment

199,847.67  x  .08  =  15,987.81

15,987.81/365  =  43.80  =  $43.80 daily interest rate

You make a payment of $1,467.53 on the 25^th day of the month

$1,095.00 goes to pay interest (43.80 x 25) and the remainder, $372.53, reduces the principal to $199,465.14.

3^rd payment

Let’s say you make your next payment on the 31^st of the following month.  That means that there would be 36 days between payments this time.

199,465.14  x  .08  =  15,957.21

15,957.21/365  =  43.72  =  $43.72 daily interest rate

Payment  =  $1,467.53

Interest accrued  =  $1,573.92  (43.72  x  36) which exceeds your monthly payment of $1,467.53 by $106.39.  This amount will come out of your next payment first, before applying the rest to newly accrued interest and then, if any remains, to principal.

This example clearly shows how, even though the interest rate (8%) stays the same and the monthly payment stays the same, the portions of that payment that go towards interest and principal will vary each month due to the change in the daily interest calculation and the number of days in between payments.  It also illustrates how important it is to make timely payments, especially on large loans with long amortization schedules.